Financial Statements

and Business Decisions

Chapter 1
Learning Objectives
 LO1-1 Recognize the information conveyed in each of the
four basic financial statements and describe how it is
used by different decision makers (investors, creditors,
and managers).
 LO1-2 Identify the role of International Financial
Reporting Standards (IFRS) in determining the content of
financial statements and how companies ensure the
accuracy of their financial statements.
SUPPLEMENTARY MATERIAL
 LO1-S1 Describe the different types of business entities.
 LO1-S2 Identify traditional and emerging services, and various
career opportunities for professional accountants.
The Accounting System and Decision Makers
Four Basic Financial Statements: An Overview
 Four financial statements are normally prepared by profit-
making organizations for use by shareholders, creditors,
and other external decision makers.
 Statement of financial position: reports the economic
resources it owns and the sources of financing for those
resources.
 Statement of earnings (the main component of the statement
of comprehensive income): reports its ability to sell goods for
more than their cost to acquire and sell.
 Statement of changes in equity: reports additional
contributions from or payments to shareholders, and the
amount of earnings the company reinvested for future growth.
 Statement of cash flows: reports its ability to generate cash
and how it was used.
The Statement of Financial Position
 The purpose of the statement of financial position
(balance sheet) is to report the financial position
(amount of assets, liabilities, and shareholders’ equity) of
an accounting entity at a particular point in time. 

 The heading of the statement of financial position

identifies four significant items related to the statement:
 Name of the accounting entity
 Title of the statement
 Specific date of the statement
 Unit of measure
The Statement of Financial Position Continued
 The organization for which financial data are to be
collected and reported is called an accounting entity
 Statement of financial position has three major captions:
assets, liabilities, and shareholders’ equity. The basic
accounting equation explains their relationship:

Assets = Liabilities + Shareholders’ Equity

Financing from creditors Financing from

Economic resources
(e.g., amounts owed to shareholders
(e.g., cash,    
suppliers, employees, (e.g., contributed capital,
inventory, buildings)
banks) retained earnings)
SFP: Elements Part 1
 Assets are economic resources controlled by the entity as
a result of past business events.

 Liabilities and shareholders’ equity are the sources of

financing for the company’s economic resources.

 Liabilities indicate the amount of financing provided by

creditors. They are the company’s debts or obligations. 
SFP: Elements Part 2
 Shareholders’ equity indicates the amount of financing
provided by owners of the business and reinvested
earnings.
 The investment of cash and other assets in the business by the
shareholders is called contributed capital.
 The amount of earnings (profits) reinvested in the business
(and thus not distributed to shareholders in the form of
dividends) is called retained earnings.
SFP: Format Part 1
 Assets may be listed on the statement of financial
position in either increasing or decreasing order of their
convertibility to cash.
 Most Canadian companies list their assets beginning with
the most-liquid asset, cash, and ending with the least-
liquid assets.
 In contrast, many international companies, list their least-
liquid assets first and most-liquid assets last.
 Similarly, liabilities may be listed by either increasing or
decreasing order of maturity (due date).
SFP: Format Part 2
 Most financial statements include the monetary unit sign
(in Canada, $) beside the first amount in a group of items
(e.g., the cash amount in the assets).
 It is common to place a single underline below the last
item in a group before a total or subtotal (e.g., Other
assets).
 A double underline is placed below group totals (e.g.,
Total assets).
 The same conventions are followed in all four basic
financial statements.
The Statement of Earnings
 The statement of earnings (also called income statement,
statement of operations, statement of comprehensive
income) reports the accountant’s primary measure of
performance of a business, revenues less expenses during
the accounting period.

 While the term profit is used widely for this measure of

performance, accountants prefer to use the technical
terms net income or net earnings.
The Statement of Earnings Continued

Revenues − Expenses = Net Earnings

Resources used
Cash and promises Revenues earned
to earn the
received from delivery     minus expenses
of goods and services period’s incurred
revenues
The Statement of Earnings: Elements
 Companies earn revenues from the sale of goods or
services to customers. Revenues normally are amounts
expected to be received for goods or services that have
been delivered to a customer, whether or not the
customer has paid for the goods or services. 
 Expenses represent the monetary value of resources the
entity used up, or consumed, to earn revenues during the
period. 
 Net earnings (also called the “bottom line”) is the excess
of total revenues over total expenses incurred to
generate revenue during a specific period. 
The Statement of Changes in Equity
 The statement of changes in equity reports all changes to
shareholders’ equity during the accounting period.
 This statement reports how net earnings, distribution of
net earnings (dividends), and other changes to
shareholders’ equity affected the company’s financial
position during the accounting period.
Equity, beginning of the period
Plus: Net earnings for the year
Plus: Other comprehensive income
Less: Dividends
Plus/Less: Other changes, net
Equity, end of the period
The Statement of Cash Flows Part 1
 The statement of cash flows divides a company's cash
inflows (receipts) and outflows (payments) into three
primary categories of cash flows in a typical business:
cash flows from operating, investing, and financing
activities.
 The specifics of a complete statement of cash flows are
discussed in Chapter 5.
The Statement of Cash Flows Part 2
 Reported revenues do not always equal cash collected
because some sales may be on credit.
 Expenses reported on the statement of earnings may not
be equal to cash paid out during the period because
expenses may be incurred in one period and paid for in
another.
 Net earnings (revenues minus expenses) does not usually
equal the amount of cash received minus the amount
paid during the period.
 Therefore, because the statement of earnings does not
provide information concerning cash flows, the statement
of cash flows is prepared to report inflows and outflows
of cash.
The Statement of Cash Flows Part 3
 The statement of cash flows equation describes the
causes of the change in cash reported on the statement
of financial position from the end of the last period to the
end of the current period:

+/− Cash flows from operating activities

+/− Cash flows from investing activities
+/− Cash flows from financing activities
  Change in cash
+  Beginning Cash Balance
=  Ending Cash Balance
The Statement of Cash Flows: Elements
 Cash flows from operating activities (CFO) are cash flows
that are directly related to generating earnings.

 Cash flows from investing activities (CFI) include cash

flows related to the acquisition or sale of the company’s
property, plant, and equipment, and investments.

 Cash flows from financing activities (CFF) are directly

related to the financing of the company itself. They
involve both receipts and payments of cash from/to
investors and creditors (except for suppliers).
Relationships Among the Statements
1. Net earnings from the statement of earnings results in
an increase in ending retained earnings on the
statement of changes in equity.
2. Ending retained earnings from the statement of
changes in equity is one of the three components of
shareholders’ equity on the statement of financial
position.
3. The change in cash on the statement of cash flows
added to the cash balance at the beginning of the year
equals the balance of cash at the end of the year, which
appears on the statement of financial position. 
Relationships Among the Statements: LeNature
Notes to Financial Statements
 Notes provide supplemental information about the
financial condition of a company, without which the
financial statements cannot be fully understood. 
 There are three basic types of notes.
1. The first type provides descriptions of the accounting
rules applied in the company’s statements.
2. The second presents additional detail about a line on
the financial statements.
3. The third type of note presents additional financial
disclosures about items not listed on the statements
themselves.
Responsibilities for the Accounting
Communication Process
 Effective communication means that the recipient
understands what the sender intends to convey.

 Understandability is the foundation of effective

communication.

 Decision makers also need to understand

the measurement rules applied in computing the
numbers on the statements. 
How are Accounting Standards Determined?
 Our accounting system has a long and distinguished
history. An Italian monk named Luca Pacioli, published
the first elements of double-entry bookkeeping in 1494.

 Prior to 1933, the management teams of most companies

were largely free to choose their own financial reporting
practices.
Accounting Standards Board (AcSB)
 In Canada, the Accounting Standards Board (AcSB) is the
private-sector body given primary responsibility to set the
detailed rules that become accepted accounting
standards.
 The AcSB is responsible for establishing standards of
accounting and reporting by publicly accountable
enterprises, private enterprises, government
organizations, and not-for-profit organizations.
 These standards or recommendations, which are
published in CPA Canada Handbook, have expanded over
time because of the increasing diversity and complexity
of business practices.
International Financial Reporting Standards
 For Canadian publicly accountable enterprises, the AcSB
has determined that they must prepare their financial
statements in accordance with International Financial
Reporting Standards. 
 IFRS are a single set of globally accepted high-quality
standards, produced by the International Accounting
Standards Board (IASB), which is an independent
standard-setting board responsible for the development
and publication of IFRS.
 An older set of International Accounting Standards (IAS)
were issued by the Board of the International Accounting
Standards Committee, and they complement the
accounting standards issued by the IASB.
Why Accounting Standards are Important
 Companies, their managers, and their owners are most
directly affected by the information presented in the
financial statements.
 Companies incur the cost of preparing the statements
and bear the major economic consequences of their
publication. These economic consequences include,
among others, the following:
 Changes to the selling price of a company’s shares
 Changes to the amount of bonuses received by management
and employees
 The loss of competitive advantage over other companies
Ethical Conduct
 Ethics are standards of conduct for judging right from
wrong, honest from dishonest behaviour, and fair from
unfair practices.

 Intentional misreporting of financial statements is both

unethical and illegal.

 Many situations are less clear-cut and require that

individuals weigh one moral principle (e.g., honesty)
against another (e.g., loyalty to a friend).
Ethical Conduct Continued
 When facing an ethical dilemma the following three-step
process should be followed:
1. Identify the effects of the decision on both parties,
those who will benefit from the situation (often the
manager or employee involved) and those who will
be harmed (other employees, owners, creditors, the
environment).
2. Identify alternative courses of action.
3. Choose the alternative that you would like to see
reported on the news. That is usually the ethical
choice.
Management Responsibility & the Demand for
Auditing
 Primary responsibility for setting up systems to prevent
and detect unethical behaviour lies with management, as
represented by the highest officer of the company and its
highest financial officer.
 Companies take three important steps to assure investors
that the company’s records are accurate:
1. They develop and maintain a system of internal controls over
both the records and the assets of the company,
2. They hire outside independent auditors to attest to the
fairness of the statement presentations, and
3. They form a committee of the board of directors to oversee
the integrity of these two safeguards.
Management Responsibility & the Demand for
Auditing Continued
Independent Auditor
 The role of the independent auditor is to examine the
financial reports to ensure that they represent what they
claim and conform to generally accepted accounting
principles.

 In performing an audit, the independent auditor

examines the underlying transactions and the accounting
methods used to account for these transactions. 
Legal Liability, Professional Conduct, and
Independence
 The Canadian accounting profession requires its members
to adhere to a code of professional conduct and
standards of independence.
 These standards are enforced through a disciplinary
process.
 The provincial CPA institutes all stress how important it is
for each member to behave in ways that enhance the
reputation of the profession through voluntary
compliance.
 In addition, CPA Canada treats professional and ethical
behaviour as the most important of the enabling
competencies possessed by its members.
 Appendix 1A: Comparison of Three Types of
Business Entities

  Proprietorship Partnership Corporation

Two or more
Number of owners One owner Many owners
owners

Not separate Not separate

Legal status of entity from that of its from that of its Separate legal entity
owner owners

Responsibility of Owners’ liability

Unlimited legal Unlimited legal
owners for debts of limited to their
liability liability
business entity investment

Each entity is separate from its owners for accounting

Accounting status
purposes
Appendix 1B: Employment in the Accounting
Profession Today
 Accountants are usually engaged in professional practice
or employed by businesses, government entities, and not-
for-profit organizations.
 Practice of Public Accounting:
 Audit or assurance services, management consulting and
advisory services, and tax services.
 Employment by Organizations:
 External reporting, tax planning, control of assets etc.
 Employment by Public and Not-for-Profit Sectors
 Charitable organizations, hospitals and universities.
End of Chapter Summary
 Four basic financial statements:
 The Statement of Financial Position
 The Statement of Comprehensive Income
 The Statement of Changes in Equity
 The Statement of Cash Flows
End of Chapter Summary Continued
 IFRS are the broad principles, specific rules, and practices
used to develop and report the information in financial
statements.
 Knowledge of IFRS is necessary to accurately interpret the
numbers in financial statements.
 Management has primary responsibility for the accuracy
of a company’s financial information.
 Auditors are responsible for expressing an opinion on the
fairness of the financial statement presentations based
on their examination of the reports and records of the
company.